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Why choose equity vs. debt financing?

07 Jan 2019

Start with asking yourself one question: “What kind of financing do we need?” There are two main types of financing to consider: debt, which is in essence a loan that is paid back with regular interest payments, and equity, which involves the exchange of company shares for capital.


A mature business will likely have a combination of equity and debt financing; in fact, it is healthy to do so, but each type is suited to specific goals, business models, and stages of development in a company’s lifecycle. They each have pros and cons. We at Eureeca focus on equity financing but when we think debt financing is more suitable we will recommend the entrepreneur go to a peer-to-peer/business debt platform instead. Likewise, those platforms refer deals to us when equity is the better option.

Here’s a breakdown of equity vs. debt financing:

Debt

Debt financing typically comes in the form of a loan or a bond that is paid back at a predetermined interest rate over a fixed period of time. For example, you can take a loan out from a bank (HEALTH WARNING - banks don’t lend to SMEs so don’t waste too much time there) in order to hire new staff, or you can issue a bond to an investor that will pay an interest rate, or coupon, and must be paid back or repurchased by the issuer at a fixed future point in time, known as the maturity date.

Debt is ideal for cashflow purposes -- e.g. if you need to buy new inventory for your shop, which you know you will sell within a few months -- and one of its primary advantages over equity financing is that you avoid giving up any company ownership, or equity.

Debt has to be paid back, which necessitates regularly having cash on hand. If you’re focused on growth and are interesting in pumping your revenues back into the business, these interest payments can put a crunch on your finances. Even more concerning, though, is it if your business goes bust, which is a real risk for early-stage SMEs, then it is likely the debt will be passed to you as an entrepreneur. This is not a situation you want to find yourself in when you’ve just gone out of business.

For investors, providing debt financing to early-stage businesses in particular also doesn’t make a lot of sense in that the investment will often carry the same risk profile as an equity investment but doesn’t offer the same upside in terms of returns. The best they can do is receive their relatively low returns from interest payments, but there is also a reasonable chance of total capital loss, just like an equity investment. This is largely why banks don’t issue loans to early-stage businesses. The risk-reward profile isn’t appealing.
 
Equity

Businesses looking to achieve rapid growth should consider equity, which involves selling off stakes of your business in exchange for capital. The main disadvantage is, as ...

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